XNAS:EA Electronic Arts Inc Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
 
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2012
OR
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from              to            
Commission File No. 000-17948
ELECTRONIC ARTS INC.
(Exact name of registrant as specified in its charter)
 
Delaware
94-2838567
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
 
 
209 Redwood Shores Parkway
Redwood City, California
94065
(Address of principal executive offices)
(Zip Code)
(650) 628-1500
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  þ    NO  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES  þ    NO  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
þ
Accelerated filer                   
¨
Non-accelerated filer
(Do not check if a smaller reporting company)

¨
Smaller reporting company 
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  ¨    NO  þ
As of August 1, 2012, there were 318,393,935 shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding.

1


ELECTRONIC ARTS INC.
FORM 10-Q
FOR THE PERIOD ENDED JUNE 30, 2012
Table of Contents
 
 
 
Page
 
Item 1.
 
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 6.

2


PART I – FINANCIAL INFORMATION

Item 1.
Condensed Consolidated Financial Statements (Unaudited)
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
 
(Unaudited)
(In millions, except par value data)
June 30,
2012
 
March 31,
2012 (a)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
919

 
$
1,293

Short-term investments
444

 
437

Marketable equity securities
76

 
119

Receivables, net of allowances of $226 and $252, respectively
111

 
366

Inventories
60

 
59

Deferred income taxes, net
68

 
67

Other current assets
273

 
268

Total current assets
1,951

 
2,609

Property and equipment, net
558

 
568

Goodwill
1,716

 
1,718

Acquisition-related intangibles, net
347

 
369

Deferred income taxes, net
44

 
42

Other assets
209

 
185

TOTAL ASSETS
$
4,825

 
$
5,491

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
50

 
$
215

Accrued and other current liabilities
702

 
857

Deferred net revenue (packaged goods and digital content)
584

 
1,048

Total current liabilities
1,336

 
2,120

0.75% convertible senior notes due 2016, net
544

 
539

Income tax obligations
198

 
189

Deferred income taxes, net
2

 
8

Other liabilities
193

 
177

Total liabilities
2,273

 
3,033

Commitments and contingencies (See Note 11)

 

Stockholders’ equity:
 
 
 
Preferred stock, $0.01 par value. 10 shares authorized

 

Common stock, $0.01 par value. 1,000 shares authorized; 318 and 320 shares issued and outstanding, respectively
3

 
3

Paid-in capital
2,310

 
2,359

Retained earnings (accumulated deficit)
124

 
(77
)
Accumulated other comprehensive income
115

 
173

Total stockholders’ equity
2,552

 
2,458

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
4,825

 
$
5,491

See accompanying Notes to Condensed Consolidated Financial Statements (unaudited).
 
(a) Derived from audited consolidated financial statements.

3


ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 
(Unaudited)
Three Months Ended
June 30,
(In millions, except per share data)
2012
 
2011
Net revenue:
 
 
 
Product
$
702

 
$
894

Service and other
253

 
105

Total net revenue
955

 
999

Cost of revenue:
 
 
 
Product
132

 
212

Service and other
73

 
28

Total cost of revenue
205

 
240

Gross profit
750

 
759

Operating expenses:
 
 
 
Research and development
290

 
285

Marketing and sales
145

 
140

General and administrative
86

 
74

Acquisition-related contingent consideration
(20
)
 
2

Amortization of intangibles
7

 
13

Restructuring and other charges
27

 
18

Total operating expenses
535

 
532

Operating income
215

 
227

Interest and other income (expense), net
(5
)
 
3

Income before provision for income taxes
210

 
230

Provision for income taxes
9

 
9

Net income
$
201

 
$
221

Net income per share:
 
 
 
Basic
$
0.63

 
$
0.67

Diluted
$
0.63

 
$
0.66

Number of shares used in computation:
 
 
 
Basic
317

 
331

Diluted
320

 
337

See accompanying Notes to Condensed Consolidated Financial Statements (unaudited).


4


ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)
Three Months Ended
June 30,
(In millions)
2012
 
2011
Net income
$
201

 
$
221

Other comprehensive income (loss), net of tax:
 
 
 
Change in unrealized gains on available-for-sale securities
(42
)
 
13

Reclassification adjustment for realized losses on derivative instruments
1

 
2

Foreign currency translation adjustments
(17
)
 
6

Total other comprehensive income (loss), net of tax
(58
)
 
21

Total comprehensive income
$
143

 
$
242


See accompanying Notes to Condensed Consolidated Financial Statements (unaudited).


5



ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended
June 30,
(In millions)
2012
 
2011
OPERATING ACTIVITIES
 
 
 
Net income
$
201

 
$
221

Adjustments to reconcile net income to net cash used in operating activities:
 
 
 
Depreciation, amortization and accretion, net
56

 
43

Stock-based compensation
39

 
38

Acquisition-related contingent consideration
(20
)
 
2

Non-cash restructuring charges
7

 

Change in assets and liabilities:
 
 
 
Receivables, net
254

 
307

Inventories
(2
)
 
4

Other assets
(29
)
 
(101
)
Accounts payable
(157
)
 
(133
)
Accrued and other liabilities
(119
)
 
(181
)
Deferred income taxes, net
(10
)
 
1

Deferred net revenue (packaged goods and digital content)
(464
)
 
(475
)
Net cash used in operating activities
(244
)
 
(274
)
INVESTING ACTIVITIES
 
 
 
Capital expenditures
(31
)
 
(32
)
Proceeds from maturities and sales of short-term investments
128

 
83

Purchase of short-term investments
(137
)
 
(90
)
Acquisition of subsidiaries, net of cash acquired

 
(25
)
Net cash used in investing activities
(40
)
 
(64
)
FINANCING ACTIVITIES
 
 
 
Proceeds from issuance of common stock

 
14

Excess tax benefit from stock-based compensation

 
2

Repurchase and retirement of common stock
(71
)
 
(91
)
Acquisition-related contingent consideration payment
(1
)
 

Net cash used in financing activities
(72
)
 
(75
)
Effect of foreign exchange on cash and cash equivalents
(18
)
 
7

Decrease in cash and cash equivalents
(374
)
 
(406
)
Beginning cash and cash equivalents
1,293

 
1,579

Ending cash and cash equivalents
$
919

 
$
1,173

Supplemental cash flow information:
 
 
 
Cash paid (refunded) during the period for income taxes, net
$
8

 
$
(18
)
Non-cash investing activities:
 
 
 
Change in unrealized gains on available-for-sale securities, net of taxes
$
(42
)
 
$
13

See accompanying Notes to Condensed Consolidated Financial Statements (unaudited).


6


ELECTRONIC ARTS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(1) DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

We develop, market, publish and distribute game software content and services that can be played by consumers on a variety of platforms, including video game consoles (such as the Sony PLAYSTATION 3, Microsoft Xbox 360, and Nintendo Wii), personal computers, mobile devices (such as the Apple iPhone and Google Android compatible phones), tablets and electronic readers (such as the Apple iPad and Amazon Kindle), and the Internet. Our ability to publish games across multiple platforms, through multiple distribution channels, and directly to consumers (online and wirelessly) has been, and will continue to be, a cornerstone of our product strategy. We have generated substantial growth in new business models and alternative revenue streams (such as subscription, micro-transactions, and advertising) based on the continued expansion of our online and wireless platform. Some of our games are based on our own wholly-owned intellectual property (e.g., Battlefield, Mass Effect, Need for Speed, The Sims, Bejeweled, and Plants v. Zombies), and some of our games are based on content that we license from others (e.g., FIFA, Madden NFL, and Star Wars: The Old Republic). Our goal is to turn our core intellectual properties into year-round businesses available on a range of platforms. Our products and services may be purchased through physical and online retailers, platform providers such as console manufacturers and mobile carriers via digital downloads, as well as directly through our own distribution platform, including online portals such as Origin and Play4Free.
Our fiscal year is reported on a 52- or 53-week period that ends on the Saturday nearest March 31. Our results of operations for the fiscal years ending or ended, as the case may be, March 31, 2013 and 2012 contain 52 weeks each, and ends or ended, as the case may be, on March 30, 2013 and March 31, 2012, respectively. Our results of operations for the three months ended June 30, 2012 and 2011 contained 13 weeks each, and ended on June 30, 2012 and July 2, 2011, respectively. For simplicity of disclosure, all fiscal periods are referred to as ending on a calendar month end.
The Condensed Consolidated Financial Statements are unaudited and reflect all adjustments (consisting only of normal recurring accruals unless otherwise indicated) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. The preparation of these Condensed Consolidated Financial Statements requires management to make estimates and assumptions that affect the amounts reported in these Condensed Consolidated Financial Statements and accompanying notes. Actual results could differ materially from those estimates. The results of operations for the current interim periods are not necessarily indicative of results to be expected for the current year or any other period.
These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2012, as filed with the United States Securities and Exchange Commission (“SEC”) on May 25, 2012.

(2) FAIR VALUE MEASUREMENTS
Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining fair value, we consider the principal or most advantageous market in which we would transact and consider assumptions that market participants would use when pricing the asset or liability. We measure certain financial and nonfinancial assets and liabilities at fair value on a recurring and nonrecurring basis.
Fair Value Hierarchy
The three levels of inputs that may be used to measure fair value are as follows:
Level 1. Quoted prices in active markets for identical assets or liabilities.
Level 2. Observable inputs other than quoted prices included within Level 1, such as quoted prices for similar assets or liabilities, quoted prices in markets with insufficient volume or infrequent transactions (less active markets), or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities.
Level 3. Unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of assets or liabilities.

7


Assets and Liabilities Measured at Fair Value on a Recurring Basis
As of June 30, 2012 and March 31, 2012, our assets and liabilities that were measured and recorded at fair value on a recurring basis were as follows (in millions):
 
 
 
 
Fair Value Measurements at Reporting Date Using
 
  
 
 
 
Quoted Prices in
Active Markets 
for Identical
Financial
Instruments
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
 
 
 
As of
June 30,
2012
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
Balance Sheet Classification
Assets
 
 
 
 
 
 
 
 
 
Money market funds
$
253

 
$
253

 
$

 
$

 
Cash equivalents
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
Corporate bonds
181

 

 
181

 

 
Short-term investments and cash equivalents
U.S. Treasury securities
141

 
141

 

 

 
Short-term investments and cash equivalents
U.S. agency securities
109

 

 
109

 

 
Short-term investments
Marketable equity securities
76

 
76

 

 

 
Marketable equity securities
Commercial paper
22

 

 
22

 

 
Short-term investments and cash equivalents
Deferred compensation plan assets (a)
11

 
11

 

 

 
Other assets
Foreign currency derivatives
4

 

 
4

 

 
Other current assets
Total assets at fair value
$
797

 
$
481

 
$
316

 
$

 
 
Liabilities
 
 
 
 
 
 
 
 
 
Contingent consideration (b)
$
88

 
$

 
$

 
$
88

 
Accrued and other current liabilities and other liabilities
Total liabilities at fair value
$
88

 
$

 
$

 
$
88

 
 

 
 
 
Fair Value Measurements Using Significant
Unobservable Inputs (Level 3)
 
 
 
 
 
 
 
 
 
Contingent
Consideration
 
 
Balance as of March 31, 2012
 
 
 
 
 
 
$
112

 
 
Change in fair value (c)
 
 
 
 
 
 
(20
)
 
 
Payments (d)
 
 
 
 
 
 
(4
)
 
 
Balance as of June 30, 2012
 
 
 
 
 
 
$
88

 
 

 

8


 
 
 
Fair Value Measurements at Reporting Date Using
 
  
 
 
 
Quoted Prices in
Active Markets 
for Identical
Financial
Instruments
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
 
 
 
As of
March 31,
2012
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
Balance Sheet Classification
Assets
 
 
 
 
 
 
 
 
 
Money market funds
$
490

 
$
490

 
$

 
$

 
Cash equivalents
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
170

 
170

 

 

 
Short-term investments and cash equivalents
Corporate bonds
150

 

 
150

 

 
Short-term investments
Marketable equity securities
119

 
119

 

 

 
Marketable equity securities
U.S. agency securities
116

 

 
116

 

 
Short-term investments
Commercial paper
16

 

 
16

 

 
Short-term investments and cash equivalents
Deferred compensation plan assets (a)
11

 
11

 

 

 
Other assets
Foreign currency derivatives
2

 

 
2

 

 
Other current assets
Total assets at fair value
$
1,074

 
$
790

 
$
284

 
$

 
 
Liabilities
 
 
 
 
 
 
 
 
 
Contingent consideration (b)
$
112

 
$

 
$

 
$
112

 
Accrued and other current liabilities and other liabilities
Total liabilities at fair value
$
112

 
$

 
$

 
$
112

 
 

 
 
 
Fair Value Measurements Using Significant
Unobservable Inputs (Level 3)
 
 
 
 
 
 
 
 
 
Contingent
Consideration
 
 
Balance as of March 31, 2011
 
 
 
 
 
 
$
51

 
 
Additions
 
 
 
 
 
 
100

 
 
Change in fair value (c)
 
 
 
 
 
 
11

 
 
Payment (d)
 
 
 
 
 
 
(25
)
 
 
Reclassification (e)
 
 
 
 
 
 
(25
)
 
 
Balance as of March 31, 2012
 
 
 
 
 
 
$
112

 
 

(a)
The deferred compensation plan assets consist of various mutual funds.

(b)
The contingent consideration as of June 30, 2012 and March 31, 2012 represents the estimated fair value of the additional variable cash consideration payable primarily in connection with our acquisitions of PopCap Games, Inc. (“PopCap”), KlickNation Corporation (“KlickNation”), and Chillingo Limited (“Chillingo”) that is contingent upon the achievement of certain performance milestones. We estimated the fair value of the acquisition-related contingent consideration payable using probability-weighted discounted cash flow models, and applied a discount rate that appropriately captures a market participant's view of the risk associated with the obligation. During the three months ended June 30, 2012, the discount rate used had a weighted average of 13 percent. During fiscal year 2012, the discount rate used had a weighted average of 12 percent. The significant unobservable input used in the fair value measurement of the acquisition-related contingent consideration payable are forecasted earnings. Significant changes in forecasted earnings would result in a significantly higher or lower fair value measurement. At June 30, 2012 and March 31, 2012, the fair market value of acquisition-related contingent consideration totaled $88 million and $112 million, respectively, compared to a maximum potential payout of $568 million and $572 million, respectively.

(c)
The change in fair value is reported as acquisition-related contingent consideration in our Condensed Consolidated Statements of Operations.

(d)
During the three months ended June 30, 2012, we made a payment of $4 million to settle certain performance milestones achieved in connection with one of our acquisitions. During the fourth quarter of fiscal year 2012, we made a payment of $25 million to settle certain performance milestones achieved through December 31, 2011 in connection

9


with our acquisition of Playfish Limited (“Playfish”).

(e)
During the fourth quarter of fiscal year 2012, we reclassified $25 million of contingent consideration in connection with our acquisition of Playfish to other current liabilities in our Condensed Consolidated Balance Sheet as the contingency was settled. This amount is no longer measured at fair value on a recurring basis and is expected to be paid during the second quarter of fiscal 2013.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

During the three months ended June 30, 2012 and 2011, there were no material impairment charges for assets and liabilities measured at fair value on a nonrecurring basis in periods subsequent to initial recognition.

(3) FINANCIAL INSTRUMENTS
Cash and Cash Equivalents
As of June 30, 2012 and March 31, 2012, our cash and cash equivalents were $919 million and $1,293 million, respectively. Cash equivalents were valued at their carrying amounts as they approximate fair value due to the short maturities of these financial instruments.
Short-Term Investments
Short-term investments consisted of the following as of June 30, 2012 and March 31, 2012 (in millions): 
 
As of June 30, 2012
 
As of March 31, 2012
 
Cost or
Amortized
Cost
 
Gross Unrealized
 
Fair
Value
 
Cost or
Amortized
Cost
 
Gross Unrealized
 
Fair
Value
 
Gains
 
Losses
 
Gains
 
Losses
 
Corporate bonds
$
179

 
$
1

 
$

 
$
180

 
$
149

 
$
1

 
$

 
$
150

U.S. Treasury securities
140

 

 

 
140

 
166

 

 

 
166

U.S. agency securities
109

 

 

 
109

 
116

 

 

 
116

Commercial paper
15

 

 

 
15

 
5

 

 

 
5

Short-term investments
$
443

 
$
1

 
$

 
$
444

 
$
436

 
$
1

 
$

 
$
437

We evaluate our investments for impairment quarterly. Factors considered in the review of investments with an unrealized loss include the credit quality of the issuer, the duration that the fair value has been less than the adjusted cost basis, severity of the impairment, reason for the decline in value and potential recovery period, the financial condition and near-term prospects of the investees, our intent to sell the investments, any contractual terms impacting the prepayment or settlement process, as well as if we would be required to sell an investment due to liquidity or contractual reasons before its anticipated recovery. Based on our review, we did not consider these investments to be other-than-temporarily impaired as of June 30, 2012 and March 31, 2012.
The following table summarizes the amortized cost and fair value of our short-term investments, classified by stated maturity as of June 30, 2012 and March 31, 2012 (in millions): 
 
As of June 30,
2012
 
As of March 31,
2012
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
Short-term investments
 
 
 
 
 
 
 
Due in 1 year or less
$
215

 
$
215

 
$
207

 
$
207

Due in 1-2 years
110

 
111

 
123

 
124

Due in 2-3 years
118

 
118

 
106

 
106

Short-term investments
$
443

 
$
444

 
$
436

 
$
437


Marketable Equity Securities
Our investments in marketable equity securities consist of investments in common stock of publicly-traded companies and are accounted for as available-for-sale securities and are recorded at fair value. Unrealized gains and losses are recorded as a component of accumulated other comprehensive income in stockholders’ equity, net of tax, until either the security is sold or we determine that the decline in the fair value of a security to a level below its adjusted cost basis is other-than-temporary. We evaluate these investments for impairment quarterly. If we conclude that an investment is other-than-temporarily impaired, we

10


will recognize an impairment charge at that time in our Condensed Consolidated Statements of Operations.
Marketable equity securities consisted of the following as of June 30, 2012 and March 31, 2012 (in millions): 
 
Adjusted
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
As of June 30, 2012
$
32

 
$
44

 
$

 
$
76

As of March 31, 2012
$
32

 
$
87

 
$

 
$
119


We did not recognize any impairment charges during the three months ended June 30, 2012 and 2011 on our marketable equity securities. We did not sell any of our marketable securities during the three months ended June 30, 2012 and 2011.

0.75% Convertible Senior Notes Due 2016
The following table summarizes the carrying value and fair value of our 0.75% Convertible Senior Notes due 2016 as of June 30, 2012 and March 31, 2012 (in millions): 
 
As of June 30, 2012
 
As of March 31, 2012
 
Carrying
Value
 
Fair
Value
 
Carrying
Value
 
Fair
Value
0.75% Convertible Senior Notes due 2016
$
544

 
$
556

 
$
539

 
$
584

The carrying value of the 0.75% Convertible Senior Notes due 2016 excludes the fair value of the equity conversion feature, which was classified as equity upon issuance, while the fair value is based on quoted market prices for the 0.75% Convertible Senior Notes due 2016, which includes the equity conversion feature. The fair value of the 0.75% Convertible Senior Notes due 2016 is classified as level 2 within the fair value hierarchy. See Note 10 for additional information related to our 0.75% Convertible Senior Notes due 2016.

(4) DERIVATIVE FINANCIAL INSTRUMENTS
The assets or liabilities associated with our derivative instruments and hedging activities are recorded at fair value in other current assets or accrued and other current liabilities, respectively, on our Condensed Consolidated Balance Sheets. As discussed below, the accounting for gains and losses resulting from changes in fair value depends on the use of the derivative instrument and whether it is designated and qualifies for hedge accounting.
We transact business in various foreign currencies and have significant international sales and expenses denominated in foreign currencies, subjecting us to foreign currency risk. We purchase foreign currency option contracts, generally with maturities of 15 months or less, to reduce the volatility of cash flows primarily related to forecasted revenue and expenses denominated in certain foreign currencies. In addition, we utilize foreign currency forward contracts to mitigate foreign exchange rate risk associated with foreign-currency-denominated monetary assets and liabilities, primarily intercompany receivables and payables. The foreign currency forward contracts generally have a contractual term of approximately three months or less and are transacted near month-end. At each quarter-end, the fair value of the foreign currency forward contracts generally is not significant. We do not use foreign currency option or foreign currency forward contracts for speculative or trading purposes.
Cash Flow Hedging Activities
Our foreign currency option contracts are designated and qualify as cash flow hedges. The effectiveness of the cash flow hedge contracts, including time value, is assessed monthly using regression analysis, as well as other timing and probability criteria. To qualify for hedge accounting treatment, all hedging relationships are formally documented at the inception of the hedges and must be highly effective in offsetting changes to future cash flows on hedged transactions. The effective portion of gains or losses resulting from changes in the fair value of these hedges is initially reported, net of tax, as a component of accumulated other comprehensive income in stockholders’ equity. The gross amount of the effective portion of gains or losses resulting from changes in the fair value of these hedges is subsequently reclassified into net revenue or research and development expenses, as appropriate, in the period when the forecasted transaction is recognized in our Condensed Consolidated Statements of Operations. In the event that the gains or losses in accumulated other comprehensive income are deemed to be ineffective, the ineffective portion of gains or losses resulting from changes in fair value, if any, is reclassified to interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. In the event that the underlying forecasted transactions do not occur, or it becomes remote that they will occur, within the defined hedge period, the gains or losses on the related cash flow hedges are reclassified from accumulated other comprehensive income to interest and other income

11


(expense), net, in our Condensed Consolidated Statements of Operations. During the three months ended June 30, 2012 and 2011, we reclassified an immaterial amount of losses into interest and other income (expense), net. As of June 30, 2012, we had foreign currency option contracts to purchase approximately $30 million in foreign currency and to sell approximately $165 million of foreign currency. All of the foreign currency option contracts outstanding as of June 30, 2012 will mature in the next 12 months. As of March 31, 2012, we had foreign currency option contracts to purchase approximately $74 million in foreign currency and to sell approximately $78 million of foreign currency. As of June 30, 2012 and March 31, 2012, these foreign currency option contracts outstanding had a total fair value of $4 million and $2 million, respectively, and are included in other current assets.
The effect of the gains and losses from our foreign currency option contracts in our Condensed Consolidated Statements of Operations for the three months ended June 30, 2012 and 2011 was immaterial, and is included in interest and other income (expense), net.
Balance Sheet Hedging Activities
Our foreign currency forward contracts are not designated as hedging instruments, and are accounted for as derivatives whereby the fair value of the contracts is reported as other current assets or accrued and other current liabilities on our Condensed Consolidated Balance Sheets, and gains and losses resulting from changes in the fair value are reported in interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. The gains and losses on these foreign currency forward contracts generally offset the gains and losses in the underlying foreign-currency-denominated monetary assets and liabilities, which are also reported in interest and other income (expense), net, in our Condensed Consolidated Statements of Operations. As of June 30, 2012, we had foreign currency forward contracts to purchase and sell approximately $183 million in foreign currencies. Of this amount, $129 million represented contracts to sell foreign currencies in exchange for U.S. dollars, $47 million to purchase foreign currency in exchange for U.S. dollars, and $7 million to sell foreign currency in exchange for British pounds sterling. As of March 31, 2012, we had foreign currency forward contracts to purchase and sell approximately $242 million in foreign currencies. Of this amount, $197 million represented contracts to sell foreign currencies in exchange for U.S. dollars, $37 million to purchase foreign currency in exchange for U.S. dollars, and $8 million to sell foreign currency in exchange for British pounds sterling. As of June 30, 2012 and March 31, 2012, the fair value of our foreign currency forward contracts was immaterial and is included in accrued and other liabilities.

For the three months ended June 30, 2012, the effect of foreign currency forward contracts resulted in an $8 million gain in our Condensed Consolidated Statements of Operations included in interest and other income (expense), net. For the three months ended June 30, 2011, the effect of foreign currency forward contracts in our Condensed Consolidated Statements of Operations was immaterial, and are included in interest and other income (expense), net.

(5) GOODWILL AND ACQUISITION-RELATED INTANGIBLES, NET
The changes in the carrying amount of goodwill are as follows (in millions): 
 
EA Labels Segment
As of March 31, 2012
 
Goodwill
$
2,086

Accumulated impairment
(368
)
Total
1,718

Effects of foreign currency translation
(2
)
As of June 30, 2012
 
Goodwill
2,084

Accumulated impairment
(368
)
Total
$
1,716

Amortization of intangibles for the three months ended June 30, 2012 and 2011, are classified in the Condensed Consolidated Statement of Operations as follows (in millions):

12


 
Three Months Ended June 30,
 
2012
 
2011
Cost of product
$
9

 
$
2

Cost of service and other
6

 
1

Operating expenses
7

 
13

Total
$
22

 
16

Acquisition-related intangible assets are amortized using the straight-line method over the lesser of their estimated useful lives or the agreement terms, typically from two to fourteen years. As of June 30, 2012 and March 31, 2012, the weighted-average remaining useful life for acquisition-related intangible assets was approximately 5.5 years and 5.7 years, respectively.
Acquisition-related intangibles consisted of the following (in millions): 
 
As of June 30, 2012
 
As of March 31, 2012
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Acquisition-
Related
Intangibles, Net
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Acquisition-
Related
Intangibles, Net
Developed and core technology
$
518

 
$
(242
)
 
$
276

 
$
518

 
$
(229
)
 
$
289

Trade names and trademarks
131

 
(88
)
 
43

 
131

 
(84
)
 
47

Registered user base and other intangibles
90

 
(82
)
 
8

 
90

 
(80
)
 
10

Carrier contracts and related
85

 
(69
)
 
16

 
85

 
(67
)
 
18

In-process research and development
4

 

 
4

 
5

 

 
5

Total
$
828

 
$
(481
)
 
$
347

 
$
829

 
$
(460
)
 
$
369

As of June 30, 2012, future amortization of acquisition-related intangibles that will be recorded in cost of revenue and operating expenses is estimated as follows (in millions): 
Fiscal Year Ending March 31,
 
2013 (remaining nine months)
$
57

2014
66

2015
62

2016
50

2017
42

Thereafter
70

Total
$
347


(6) RESTRUCTURING AND OTHER CHARGES
Restructuring and other restructuring plan-related information as of June 30, 2012 was as follows (in millions): 
 
Fiscal  2013
Restructuring
 
Fiscal  2011
Restructuring
 
Other
Restructurings and Reorganization
 
 
 
Workforce
 
Facilities-
related
 
Other
 
Workforce
 
Other
 
Facilities-
related
 
Other
 
Total
Balances as of March 31, 2011
$

 
$

 
$

 
$
3

 
$
101

 
$
8

 
$
5

 
$
117

Charges to operations

 

 

 
(1
)
 
21

 
(12
)
 
8

 
16

Charges settled in cash

 

 

 
(2
)
 
(47
)
 
7

 
(13
)
 
(55
)
Balances as of March 31, 2012

 

 

 

 
75

 
3

 

 
78

Charges to operations
16

 
1

 
9

 

 
1

 

 

 
27

Charges settled in cash
(6
)
 

 
(1
)
 

 
(1
)
 

 

 
(8
)
Changes settled in non-cash

 
$

 
$
(7
)
 
$

 
$

 
$

 
$

 
$
(7
)
Balances as of June 30, 2012
$
10

 
$
1

 
$
1

 
$

 
$
75

 
$
3

 
$

 
$
90


Fiscal 2013 Restructuring

13



On May 7, 2012, we announced a restructuring plan to align our cost structure with our ongoing digital transformation. Under this plan, we are reducing our workforce, terminating licensing agreements, and consolidating or closing various facilities. We expect the majority of these actions to be completed by September 30, 2012.

Since the inception of the fiscal 2013 restructuring plan through June 30, 2012, we have incurred charges of $26 million, consisting of (1) $16 million in employee-related expenses, (2) $9 million related to license termination costs, and (3) $1 million related to the closure of certain of our facilities.

In connection with this plan, we anticipate incurring approximately $31 million to $35 million in total costs, of which approximately $22 million will result in future cash expenditures. All of these charges are expected to occur during the fiscal year ending March 31, 2013. These costs will consist of severance and other employee-related costs (approximately $16 million to $18 million), license termination costs (approximately $9 million) and other facilities-related costs (approximately $6 million to $8 million). Substantially all of these costs will be settled by March 31, 2013, with the exception of approximately $4 million of license and lease costs, which will be settled by May 2016.
Fiscal 2011 Restructuring
In fiscal year 2011, we announced a plan focused on the restructuring of certain licensing and developer agreements in an effort to improve the long-term profitability of our packaged goods business. Under this plan, we amended certain licensing and developer agreements. To a much lesser extent, as part of this restructuring we had workforce reductions and facilities closures through March 31, 2011. Substantially all of these exit activities were completed by March 31, 2011.
Since the inception of the fiscal 2011 restructuring plan through June 30, 2012, we have incurred charges of $169 million, consisting of (1) $126 million related to the amendment of certain licensing agreements and other intangible asset impairment costs, (2) $31 million related to the amendment of certain developer agreements, and (3) $12 million in employee-related expenses. The $75 million restructuring accrual as of June 30, 2012 related to the fiscal 2011 restructuring is expected to be settled by June 2016. We currently estimate recognizing in future periods through June 2016, approximately $11 million for the accretion of interest expense related to our amended licensing and developer agreements, of which $4 million will be recognized during the remainder of fiscal year 2013. This interest expense will be included in restructuring and other charges in our Condensed Consolidated Statement of Operations.
Overall, including $169 million in charges incurred through June 30, 2012, we expect to incur total cash and non-cash charges between $180 million and $185 million by June 2016. These charges will consist primarily of (1) charges, including accretion of interest expense, related to the amendment of certain licensing and developer agreements and other intangible asset impairment costs (approximately $168 million) and (2) employee-related costs ($12 million).
Other Restructurings and Reorganization
We also engaged in various other restructurings and a reorganization based on management decisions made prior to fiscal 2011. We do not expect to incur any additional restructuring charges under these plans. The $3 million restructuring accrual as of June 30, 2012 related to our other restructuring plans is expected to be settled by September 2016.

(7) ROYALTIES AND LICENSES
Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers, and (3) co-publishing and distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademarks, copyrights, personal publicity rights, content and/or other intellectual property. Royalty payments to independent software developers are payments for the development of intellectual property related to our games. Co-publishing and distribution royalties are payments made to third parties for the delivery of products.
Royalty-based obligations with content licensors and distribution affiliates are either paid in advance and capitalized as prepaid royalties or are accrued as incurred and subsequently paid. These royalty-based obligations are generally expensed to cost of revenue generally at the greater of the contractual rate or an effective royalty rate based on the total projected net revenue for contracts with guaranteed minimums. Prepayments made to thinly capitalized independent software developers and co-publishing affiliates are generally made in connection with the development of a particular product, and therefore, we are generally subject to development risk prior to the release of the product. Accordingly, payments that are due prior to completion of a product are generally expensed to research and development over the development period as the services are incurred. Payments due after completion of the product (primarily royalty-based in nature) are generally expensed as cost of revenue.


14


Our contracts with some licensors include minimum guaranteed royalty payments, which are initially recorded as an asset and as a liability at the contractual amount when no performance remains with the licensor. When performance remains with the licensor, we record guarantee payments as an asset when actually paid and as a liability when incurred, rather than recording the asset and liability upon execution of the contract. Royalty liabilities are classified as current liabilities to the extent such royalty payments are contractually due within the next 12 months.
Each quarter, we also evaluate the expected future realization of our royalty-based assets, as well as any unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized through product sales. Any impairments or losses determined before the launch of a product are charged to research and development expense. Impairments or losses determined post-launch are charged to cost of revenue. We evaluate long-lived royalty-based assets for impairment generally using undiscounted cash flows when impairment indicators exist. Unrecognized minimum royalty-based commitments are accounted for as executory contracts, and therefore, any losses on these commitments are recognized when the underlying intellectual property is abandoned (i.e., cease use) or the contractual rights to use the intellectual property are terminated. During the three months ended June 30, 2012, we recognized losses of $9 million on our previously unrecognized minimum royalty-based commitments related to our fiscal 2013 restructuring. During the three months ended June 30, 2011, we recognized an additional loss of $15 million representing an adjustment to our fiscal 2011 restructuring. The losses related to restructuring and other plan-related activities are presented in Note 6.
The current and long-term portions of prepaid royalties and minimum guaranteed royalty-related assets, included in other current assets and other assets, consisted of (in millions): 
 
As of
June 30,
2012
 
As of
March 31,
2012
Other current assets
$
90

 
$
85

Other assets
113

 
102

Royalty-related assets
$
203

 
$
187

At any given time, depending on the timing of our payments to our co-publishing and/or distribution affiliates, content licensors, and/or independent software developers, we recognize unpaid royalty amounts owed to these parties as accrued liabilities. The current and long-term portions of accrued royalties, included in accrued and other current liabilities and other liabilities, consisted of (in millions): 
 
As of
June 30,
2012
 
As of
March 31,
2012
Accrued and other current liabilities
$
110

 
$
121

Other liabilities
52

 
52

Royalty-related liabilities
$
162

 
$
173

As of June 30, 2012, $1 million of restructuring accruals related to the fiscal 2013 restructuring plan, and $75 million of restructuring accruals related to the fiscal 2011 restructuring plan are included in royalty-related liabilities in the table above. See Note 6 for details of restructuring and other restructuring plan-related activities and Note 8 for the details of our accrued and other current liabilities.
In addition, as of June 30, 2012, we were committed to pay approximately $806 million to content licensors, independent software developers, and co-publishing and/or distribution affiliates, but performance remained with the counterparty (i.e., delivery of the product or content or other factors) and such commitments were therefore not recorded in our Condensed Consolidated Financial Statements.

(8) BALANCE SHEET DETAILS
Inventories
Inventories as of June 30, 2012 and March 31, 2012 consisted of (in millions): 
 
As of
June 30,
2012
 
As of
March 31,
2012
Raw materials and work in process
$
2

 
$

Finished goods
58

 
59

Inventories
$
60

 
$
59


15


Property and Equipment, Net
Property and equipment, net, as of June 30, 2012 and March 31, 2012 consisted of (in millions): 
 
As of
June 30,
2012
 
As of
March 31,
2012
Computer equipment and software
$
613

 
$
575

Buildings
334

 
339

Leasehold improvements
122

 
121

Office equipment, furniture and fixtures
71

 
72

Land
63

 
64

Construction in progress
8

 
38

Warehouse equipment and other
10

 
10

 
1,221

 
1,219

Less: accumulated depreciation
(663
)
 
(651
)
Property and equipment, net
$
558

 
$
568

Depreciation expense associated with property and equipment was $28 million and $25 million for the three months ended June 30, 2012 and 2011, respectively.
Acquisition-Related Restricted Cash Included in Other Current Assets
Included in other current assets on our Condensed Consolidated Balance Sheets was $31 million of acquisition-related restricted cash as of June 30, 2012 and March 31, 2012. As these deposits are restricted in nature, they are excluded from cash and cash equivalents.
Accrued and Other Current Liabilities
Accrued and other current liabilities as of June 30, 2012 and March 31, 2012 consisted of (in millions): 
 
As of
June 30,
2012
 
As of
March 31,
2012
Other accrued expenses
$
351

 
$
441

Accrued compensation and benefits
148

 
233

Deferred net revenue (other)
117

 
85

Accrued royalties
86

 
98

Accrued and other current liabilities
$
702

 
$
857

Deferred net revenue (other) includes the deferral of subscription revenue, deferrals related to our Switzerland distribution business, advertising revenue, licensing arrangements, and other revenue for which revenue recognition criteria has not been met.
Deferred Net Revenue (Packaged Goods and Digital Content)
Deferred net revenue (packaged goods and digital content) was $584 million and $1,048 million as of June 30, 2012 and March 31, 2012, respectively. Deferred net revenue (packaged goods and digital content) includes the unrecognized revenue from (1) bundled sales of certain online-enabled packaged goods and digital content for which either we do not have VSOE for the online service that we provide in connection with the sale of the software or we have an obligation to provide future incremental unspecified digital content, (2) certain packaged goods sales of MMO role-playing games, and (3) sales of certain incremental content associated with our core subscription services that can only be played online, which are types of “micro-transactions.” We recognize revenue from sales of online-enabled packaged goods and digital content for which (1) we do not have VSOE for the online service that we provided in connection with the sale and (2) we have an obligation to deliver incremental unspecified digital content in the future without an additional fee on a straight-line basis generally over an estimated six-month period beginning in the month after shipment. However, we expense the cost of revenue related to these transactions during the period in which the product is delivered (rather than on a deferred basis).



16


(9) INCOME TAXES
We estimate our annual effective tax rate at the end of each quarterly period, and we record the tax effect of certain discrete items, which are unusual or occur infrequently, in the interim period in which they occur, including changes in judgment about deferred tax valuation allowances. In addition, jurisdictions with a projected loss for the year, jurisdictions with a year-to-date loss where no tax benefit can be recognized, and jurisdictions where we are unable to estimate an annual effective tax rate are excluded from the estimated annual effective tax rate. The impact of such an exclusion could result in a higher or lower effective tax rate during a particular quarter depending on the mix and timing of actual earnings versus annual projections.
We recognize deferred tax assets and liabilities for both the expected impact of differences between the financial statement amount and the tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax losses and tax credit carry forwards. We record a valuation allowance against deferred tax assets when it is considered more likely than not that all or a portion of our deferred tax assets will not be realized. In making this determination, we are required to give significant weight to evidence that can be objectively verified. It is generally difficult to conclude that a valuation allowance is not needed when there is significant negative evidence, such as cumulative losses in recent years. Forecasts of future taxable income are considered to be less objective than past results, particularly in light of the economic environment. Therefore, cumulative losses weigh heavily in the overall assessment. Based on the assumptions and requirements noted above, we have recorded a valuation allowance against most of our U.S. deferred tax assets. In addition, we expect to provide a valuation allowance on future U.S. tax benefits until we can sustain a level of profitability or until other significant positive evidence arises that suggest that these benefits are more likely than not to be realized.
The provision for income taxes reported for the three months ended June 30, 2012 is based on our projected annual effective tax rate for fiscal year 2013, and also includes certain discrete tax benefits recorded during the period. Our effective tax rate for the three months ended June 30, 2012 was 4.3 percent as compared to 3.9 percent for the three months ended June 30, 2011. The effective tax rate for the three months ended June 30, 2012 differs from the statutory rate of 35.0 percent primarily due to the utilization of U.S. deferred tax assets which were subject to a valuation allowance, and non-U.S. profits subject to a reduced or zero tax rate.
The total gross unrecognized tax benefits as of June 30, 2012 is $274 million, of which approximately $43 million is offset by prior cash deposits to tax authorities for issues pending resolution. A portion of our unrecognized tax benefits will affect our effective tax rate if they are recognized upon favorable resolution of the uncertain tax positions. As of June 30, 2012, if recognized, approximately $96 million of the unrecognized tax benefits would affect our effective tax rate and approximately $165 million would result in adjustments to deferred tax assets with corresponding adjustments to the valuation allowance.
As of June 30, 2012, the combined amount of accrued interest and penalties related to uncertain tax positions included in income tax obligations on our Condensed Consolidated Balance Sheet was approximately $21 million, as compared to the same amount at March 31, 2012.
The IRS has completed its examination of our federal income tax returns through fiscal year 2005, and is currently examining our fiscal years 2006, 2007 and 2008 tax returns. We are also currently under income tax examination in Canada for fiscal years 2004 and 2005, and in France for fiscal years 2006 through 2008. We remain subject to income tax examination for several other jurisdictions including Canada for fiscal years after 2003, in France for fiscal years after 2008, in Germany for fiscal years after 2007, in the United Kingdom for fiscal years after 2009, and in Switzerland for fiscal years after 2007.
The timing of the resolution of income tax examinations is highly uncertain, and the amounts ultimately paid, if any, upon resolution of the issues raised by the taxing authorities may differ materially from the amounts accrued for each year. Although potential resolution of uncertain tax positions involve multiple tax periods and jurisdictions, it is reasonably possible that a reduction of up to $81 million of the reserves for unrecognized tax benefits may occur within the next 12 months, some of which, depending on the nature of the settlement or expiration of statutes of limitations, may affect our income tax provision (benefit) and therefore benefit the resulting effective tax rate. The actual amount could vary significantly depending on the ultimate timing and nature of any settlements.

(10) FINANCING ARRANGEMENT
0.75% Convertible Senior Notes Due 2016
In July 2011, we issued $632.5 million aggregate principal amount of 0.75% Convertible Senior Notes due 2016 (the “Notes”). The Notes are senior unsecured obligations which pay interest semiannually in arrears at a rate of 0.75 percent per annum on January 15 and July 15 of each year, beginning on January 15, 2012 and will mature on July 15, 2016, unless earlier purchased or converted in accordance with their terms prior to such date. The Notes are senior in right of payment to any unsecured indebtedness that is expressly subordinated in right of payment to the Notes.

17



The Notes are convertible into cash and shares of our common stock based on an initial conversion value of 31.5075 shares of our common stock per $1,000 principal amount of Notes (equivalent to an initial conversion price of approximately $31.74 per share). Upon conversion of the Notes, holders will receive cash up to the principal amount of each Note, and any excess conversion value will be delivered in shares of our common stock. Prior to April 15, 2016, the Notes are convertible only if (1) the last reported sale price of the common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130 percent of the conversion price ($41.26 per share) on each applicable trading day; (2) during the five business day period after any ten consecutive trading day period in which the trading price per $1,000 principal amount of notes falls below 98 percent of the last reported sale price of our common stock multiplied by the conversion rate on each trading day; or (3) specified corporate transactions, including a change in control, occur. On or after April 15, 2016 a holder may convert any of its Notes at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date. The conversion rate is subject to customary anti-dilution adjustments (for example, certain dividend distributions or tender or exchange offer of our common stock), but will not be adjusted for any accrued and unpaid interest. The Notes are not redeemable prior to maturity except for specified corporate transactions and events of default, and no sinking fund is provided for the Notes. The Notes do not contain any financial covenants.
We separately account for the liability and equity components of the Notes. The carrying amount of the equity component representing the conversion option is equal to the fair value of the Convertible Note Hedge, as described below, which is a substantially identical instrument and was purchased on the same day as the Notes. The carrying amount of the liability component was determined by deducting the fair value of the equity component from the par value of the Notes as a whole, and represents the fair value of a similar liability that does not have an associated convertible feature. A liability of $525 million as of the date of issuance was recognized for the principal amount of the Notes representing the present value of the Notes’ cash flows using a discount rate of 4.54 percent. The excess of the principal amount of the liability component over its carrying amount is amortized to interest expense over the term of the Notes using the effective interest method. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.
In accounting for $15 million of issuance costs related to the Notes issuance, we allocated $13 million to the liability component and $2 million to the equity component. Debt issuance costs attributable to the liability component are being amortized to expense over the term of the Notes, and issuance costs attributable to the equity component were netted with the equity component in additional paid-in capital.
The carrying values of the liability and equity components of the Notes are reflected in our Condensed Consolidated Balance Sheet as follows (in millions): 
  
As of
June 30, 2012
 
As of
March 31, 2012
Principal amount of Notes
$
633

 
$
633

Unamortized discount of the liability component
(89
)
 
(94
)
Net carrying amount of Notes
$
544

 
$
539

Equity component, net
$
105

 
$
105

Interest expense recognized related to the Notes are as follows (in millions): 
 
Three Months
Ended
June 30, 2012
Amortization of debt discount
$
5

Amortization of debt issuance costs
1

Coupon interest expense
1

Total interest expense related to Notes
$
7

As of June 30, 2012, the remaining life of the Notes is 4.0 years.
Convertible Note Hedge and Warrants Issuance
In addition, in July 2011, we entered into privately negotiated convertible note hedge transactions (the “Convertible Note Hedge”) with certain counterparties to reduce the potential dilution with respect to our common stock upon conversion of the Notes. The Convertible Note Hedge, subject to customary anti-dilution adjustments, provide us with the option to acquire, on a net settlement basis, approximately 19.9 million shares of our common stock at a strike price of $31.74, which corresponds to

18


the conversion price of the Notes and is equal to the number of shares of our common stock that notionally underlie the Notes. As of June 30, 2012, we have not purchased any shares under the Convertible Note Hedge. We paid $107 million for the Convertible Note Hedge, which was recorded as an equity transaction.
Separately, in July 2011 we also entered into privately negotiated warrant transactions with the certain counterparties whereby we sold to independent third parties warrants (the “Warrants”) to acquire, subject to customary anti-dilution adjustments that are substantially the same as the anti-dilution provisions contained in the Notes, up to 19.9 million shares of our common stock (which is also equal to the number of shares of our common stock that notionally underlie the Notes), with a strike price of $41.14. The Warrants could have a dilutive effect with respect to our common stock to the extent that the market price per share of its common stock exceeds $41.14 on or prior to the expiration date of the Warrants. We received proceeds of $65 million from the sale of the Warrants.

(11) COMMITMENTS AND CONTINGENCIES
Lease Commitments
As of June 30, 2012, we leased certain current facilities, furniture and equipment under non-cancelable operating lease agreements. We were required to pay property taxes, insurance and normal maintenance costs for certain of these facilities and any increases over the base year of these expenses on the remainder of our facilities.
Development, Celebrity, League and Content Licenses: Payments and Commitments
The products we produce in our studios are designed and created by our employee designers, artists, software programmers and by non-employee software developers (“independent artists” or “third-party developers”). We typically advance development funds to the independent artists and third-party developers during development of our games, usually in installment payments made upon the completion of specified development milestones. Contractually, these payments are generally considered advances against subsequent royalties on the sales of the products. These terms are set forth in written agreements entered into with the independent artists and third-party developers.
In addition, we have certain celebrity, league and content license contracts that contain minimum guarantee payments and marketing commitments that may not be dependent on any deliverables. Celebrities and organizations with whom we have contracts include: FIFA, FIFPRO Foundation, FAPL (Football Association Premier League Limited), and DFL Deutsche Fußball Liga GmbH (German Soccer League) (professional soccer); National Basketball Association (professional basketball); PGA TOUR, Tiger Woods and Augusta National (professional golf); National Hockey League and NHL Players’ Association (professional hockey); National Football League Properties, PLAYERS Inc., and Red Bear Inc. (professional football); Collegiate Licensing Company (collegiate football); Zuffa, LLC (Ultimate Fighting Championship); ESPN (content in EA SPORTS games); Hasbro, Inc. (most of Hasbro’s toy and game intellectual properties); and LucasArts and Lucas Licensing (Star Wars: The Old Republic). These developer and content license commitments represent the sum of (1) the cash payments due under non-royalty-bearing licenses and services agreements and (2) the minimum guaranteed payments and advances against royalties due under royalty-bearing licenses and services agreements, the majority of which are conditional upon performance by the counterparty. These minimum guarantee payments and any related marketing commitments are included in the table below.

The following table summarizes our unrecognized minimum contractual obligations as of June 30, 2012 (in millions): 
 
Contractual Obligations
 
 
Fiscal Year Ending March 31,
Leases (a)
 
Developer/
Licensor
Commitments
 
Marketing
 
Convertible
Notes
Interest (b)
 
Other
Purchase
Obligations
 
Total
2013 (remaining nine months)
$
41

 
$
129

 
$
51

 
$
5

 
$
6

 
$
232

2014
51

 
126

 
53

 
5

 
8

 
243

2015
43

 
114

 
34

 
5

 

 
196

2016
31

 
167

 
34

 
5

 

 
237

2017
18

 
12

 
20

 
2

 

 
52

Thereafter
36

 
258

 
83

 

 

 
377

Total
$
220

 
$
806

 
$
275

 
$
22

 
$
14

 
$
1,337

(a)
Lease commitments have not been reduced by minimum sub-lease rentals for unutilized office space resulting from our reorganization activities of approximately $6 million due in the future under non-cancelable sub-leases.
(b)
In addition to the interest payments reflected in the table above, we will be obligated to pay the $632.5 million

19


principal amount of the 0.75% Convertible Senior Notes due 2016 and any excess conversion value in shares of our common stock upon redemption after the maturity of the Notes on July 15, 2016 or earlier. See Note 10 for additional information related to our 0.75% Convertible Senior Notes due 2016.
The amounts represented in the table above reflect our unrecognized minimum cash obligations for the respective fiscal years, but do not necessarily represent the periods in which they will be recognized and expensed in our Condensed Consolidated Financial Statements. In addition, the amounts in the table above are presented based on the dates the amounts are contractually due; however, certain payment obligations may be accelerated depending on the performance of our operating results.
In addition to what is included in the table above, as of June 30, 2012, we had a liability for unrecognized tax benefits and an accrual for the payment of related interest totaling $251 million, of which we are unable to make a reasonably reliable estimate of when cash settlement with a taxing authority will occur.
In addition to what is included in the table above as of June 30, 2012, primarily in connection with our PopCap, KlickNation, and Chillingo acquisitions, we may be required to pay an additional $568 million of cash consideration based upon the achievement of certain performance milestones through March 31, 2015. As of June 30, 2012, we have accrued $88 million of contingent consideration on our Condensed Consolidated Balance Sheet representing the estimated fair value of the contingent consideration.
Legal Proceedings
In June 2008, Geoffrey Pecover filed an antitrust class action in the United States District Court for the Northern District of California, alleging that EA obtained an illegal monopoly in a discreet antitrust market that consists of “league-branded football simulation video games” by bidding for, and winning, exclusive licenses with the NFL, Collegiate Licensing Company and Arena Football League. In December 2010, the district court granted the plaintiffs' request to certify a class of plaintiffs consisting of all consumers who purchased EA's Madden NFL, NCAA Football or Arena Football video games after 2005. In May 2012, the parties reached a settlement in principle to resolve all claims related to this action. As a result, we recognized a $27 million accrual in the fourth quarter of fiscal 2012 associated with the potential settlement. In July 2012, the plaintiffs filed a motion with the court to approve the settlement. The court will hear that motion in late September 2012.
We are also subject to claims and litigation arising in the ordinary course of business. We do not believe that any liability from any reasonably foreseeable disposition of such claims and litigation, individually or in the aggregate, would have a material adverse effect on our Condensed Consolidated Financial Statements.

(12) STOCK-BASED COMPENSATION
Valuation Assumptions
We are required to estimate the fair value of share-based payment awards on the date of grant. We recognize compensation costs for stock-based payment awards to employees based on the grant-date fair value using a straight-line approach over the service period for which such awards are expected to vest.
We determine the fair value of our share-based payment awards as follows:

Restricted Stock Units, Restricted Stock, and Performance-Based Restricted Stock Units. The fair value of restricted stock units, restricted stock, and performance-based restricted stock units (other than market-based restricted stock units) is determined based on the quoted market price of our common stock on the date of grant. Performance-based restricted stock units include grants made (1) to certain members of executive management primarily granted in fiscal year 2008 and (2) in connection with certain acquisitions.

Market-Based Restricted Stock Units. Market-based restricted stock units consist of grants of performance-based restricted stock units to certain members of executive management (referred to herein as “market-based restricted stock units”). The fair value of our market-based restricted stock units is determined using a Monte-Carlo simulation model. Key assumptions for the Monte-Carlo simulation model are the risk-free interest rate, expected volatility, expected dividends and correlation coefficient.

Stock Options and Employee Stock Purchase Plan. The fair value of stock options and stock purchase rights granted pursuant to our equity incentive plans and our 2000 Employee Stock Purchase Plan (“ESPP”), respectively, is determined using the Black-Scholes valuation model based on the multiple-award valuation method. Key assumptions of the Black-Scholes valuation model are the risk-free interest rate, expected volatility, expected term and expected dividends.

20


The determination of the fair value of market-based restricted stock units, stock options and ESPP is affected by assumptions regarding subjective and complex variables. Generally, our assumptions are based on historical information and judgment is required to determine if historical trends may be indicators of future outcomes.
The estimated assumptions used in the Black-Scholes valuation model to value our stock option grants were as follows:
 
Stock Option Grants
 
Three Months Ended
June 30,
 
2012
 
2011
Risk-free interest rate
0.4 - 1.0%

 
1.0 - 1.8%

Expected volatility
41 - 46%

 
40 - 41%

Weighted-average volatility
44
%
 
40
%
Expected term
4.4 years

 
4.4 years

Expected dividends
None

 
None

There were no ESPP shares issued during the three months ended June 30, 2012 and 2011.
The estimated assumptions used in the Monte-Carlo simulation model to value our market-based restricted stock units were as follows: 
 
Three Months Ended
June 30,
 
2012
 
2011
Risk-free interest rate
0.2 - 0.4%

 
0.2 - 0.6%

Expected volatility
17 - 116%

 
14 - 83%

Weighted-average volatility
36
%
 
35
%
Expected dividends
None

 
None

Stock-Based Compensation Expense
Employee stock-based compensation expense recognized during the three months ended June 30, 2012 and 2011 was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. In subsequent periods, if actual forfeitures differ from those estimates, an adjustment to stock-based compensation expense will be recognized at that time.
The following table summarizes stock-based compensation expense resulting from stock options, restricted stock, restricted stock units and the ESPP included in our Condensed Consolidated Statements of Operations (in millions):
 
Three Months Ended
June 30,
 
2012
 
2011
Cost of revenue
$
1

 
$
1

Research and development
22

 
23

General and administrative
9

 
9

Marketing and sales
7

 
5

Stock-based compensation expense
$
39

 
$
38

During the three months ended June 30, 2012 and 2011, we did not recognize any provision for or benefit from income taxes related to our stock-based compensation expense.
As of June 30, 2012, our total unrecognized compensation cost related to stock options was $9 million and is expected to be recognized over a weighted-average service period of 2.3 years. As of June 30, 2012, our total unrecognized compensation cost related to restricted stock and restricted stock units (collectively referred to as “restricted stock rights”) was $322 million and is expected to be recognized over a weighted-average service period of 2.1 years. Of the $322 million of unrecognized compensation cost, $19 million relates to market-based restricted stock units and $1 million relates to performance-based restricted stock units.
Stock Options

21


The following table summarizes our stock option activity for the three months ended June 30, 2012:
 
Options
(in  thousands)
 
Weighted-
Average
Exercise Price
 
Weighted-Average
Remaining
Contractual Term
(in years)
 
Aggregate
Intrinsic Value
(in millions)
Outstanding as of March 31, 2012
9,744

 
$
34.17

 
 
 
 
Granted
173

 
13.12

 
 
 
 
Exercised
(4
)
 
15.13

 
 
 
 
Forfeited, cancelled or expired
(446
)
 
40.42

 
 
 
 
Outstanding as of June 30, 2012
9,467

 
33.52

 
4.61
 
$

Exercisable as of June 30, 2012
8,594

 
35.10

 
4.23
 
$

The aggregate intrinsic value represents the total pre-tax intrinsic value based on our closing stock price as of June 30, 2012, which would have been received by the option holders had all the option holders exercised their options as of that date. The weighted-average grant date fair values of stock options granted during the three months ended June 30, 2012 and 2011 were $4.75 and $7.70, respectively. We issue new common stock from our authorized shares upon the exercise of stock options.
Restricted Stock Rights
The following table summarizes our restricted stock rights activity, excluding performance-based and market-based restricted stock unit activity discussed below, for the three months ended June 30, 2012:
 
Restricted Stock
Rights
(in thousands)
 
Weighted-
Average Grant
Date Fair Value
Balance as of March 31, 2012
16,323

 
$
20.73

Granted
5,681

 
12.53

Vested
(3,518
)
 
21.79

Forfeited or cancelled
(455
)
 
13.30

Balance as of June 30, 2012
18,031

 
18.13

The weighted-average grant date fair values of restricted stock rights granted during the three months ended June 30, 2012 and 2011 were $12.53 and $22.35, respectively.
Performance-Based Restricted Stock Units
The following table summarizes our performance-based restricted stock unit activity for the three months ended June 30, 2012: 
 
Performance-
Based  Restricted
Stock Units
(in thousands)
 
Weighted-
Average Grant
Date Fair Value
Balance as of March 31, 2012
1,421

 
$
50.35

Vested
(19
)
 
15.39

Forfeited or cancelled
(50
)
 
49.60

Balance as of June 30, 2012
1,352

 
34.36

Market-Based Restricted Stock Units
Our market-based restricted stock units vest contingent upon the achievement of pre-determined market and service conditions. If these market conditions are not met but service conditions are met, the restricted stock units will not vest; however, any compensation expense we have recognized to date will not be reversed. The number of shares of common stock to be received at vesting will range from zero percent to 200 percent of the target number of stock units based on our total stockholder return (“TSR”) relative to the performance of companies in the NASDAQ-100 Index for each measurement period over a three year period. The maximum number of common shares that could vest is approximately 2 million for market-based restricted stock units.

22


The following table summarizes our market-based restricted stock unit activity for the three months ended June 30, 2012. We present shares granted at 100 percent of target of the number of stock units that may potentially vest. 
 
Market-Based
Restricted Stock
Units
(in thousands)
 
Weighted-
Average Grant
Date Fair Value
Balance as of March 31, 2012
520

 
$
34.77

Granted
670

 
10.45

Vested
(111
)
 
34.77

Forfeited or cancelled
(62
)
 
34.77

Balance as of June 30, 2012
1,017

 
18.75

Stock Repurchase Program
In February 2011, our Board of Directors authorized a program to repurchase up to $600 million of our common stock over the next 18 months. We completed our program in April 2012. We repurchased approximately 32 million shares in the open market since in the commencement of the program, including pursuant to pre-arranged stock trading plan. During three months ended June 30, 2012, we repurchased and retired approximately 4 million shares of our common stock for approximately $71 million, net of commissions.

In July 2012, our Board of Directors authorized a new program to repurchase up to $500 million of our common stock. Under the program, we may purchase stock in the open market or through privately-negotiated transactions in accordance with applicable securities laws, including pursuant to pre-arranged stock trading plans.  The timing and actual amount of the stock repurchases will depend on several factors including price, capital availability, regulatory requirements, alternative investment opportunities and other market conditions. We are not obligated to repurchase any specific number of shares under the program and the repurchase program may be modified, suspended or discontinued at any time.
Annual Meeting of Stockholders
At our Annual Meeting of Stockholders, held on July 26, 2012, our stockholders approved amendments to our 2000 Equity Incentive Plan (the “Equity Plan”) to increase the number of shares of common stock authorized under the Equity Plan by 6,180,000 shares, and to increase the limit on the number of shares that may be covered by equity awards to eligible persons under the Equity Plan in a fiscal year.

(13) NET INCOME PER SHARE

The following table summarizes the computations of basic earnings per share (“Basic EPS”) and diluted earnings per share (“Diluted EPS”). Basic EPS is computed as net income divided by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock-based compensation plans including stock options, restricted stock, restricted stock units, common stock through our ESPP, warrants, and other convertible securities using the treasury stock method.
 
Three Months Ended
June 30,
(In millions, except per share data)
2012
 
2011
Net income
$
201

 
$
221

Shares used to compute net income per share:
 
 
 
Weighted-average common stock outstanding - basic
317

 
331

Dilutive potential common shares
3

 
6

Weighted-average common stock outstanding - diluted
320

 
337

Net income per share:
 
 
 
Basic
$
0.63

 
$
0.67

Diluted
$
0.63

 
$
0.66


For the three months ended June 30, 2012 and 2011, options to purchase, restricted stock units and restricted stock to be released in the amount of 21 million shares and 12 million shares of common stock, respectively, were excluded from the treasury stock method computation of diluted shares as their inclusion would have had an antidilutive effect.

23



Potentially dilutive shares of common stock related to our 0.75% Convertible Senior Notes due 2016 issued during the fiscal year ended March 31, 2012, which have a conversion price of $31.74 per share and the associated Warrants, which have a conversion price of $41.14 per share were excluded from the computation of Diluted EPS for the three months ended June 30, 2012 as their inclusion would have had an antidilutive effect resulting from the conversion price. The associated Convertible Note Hedge was excluded from the calculation of diluted shares as the impact is always considered antidilutive since the call option would be exercised by us when the exercise price is lower than the market price. See Note 10 for additional information related to our 0.75% Convertible Senior Notes due 2016 and related Convertible Note Hedge and Warrants.

(14) SEGMENT INFORMATION

Our reporting segments are based upon: our internal organizational structure; the manner in which our operations are managed; the criteria used by our Chief Executive Officer, our Chief Operating Decision Maker (“CODM”), to evaluate segment performance; the availability of separate financial information; and overall materiality considerations.

Our business is currently organized around our six operating labels, EA Games, EA SPORTS, Maxis, BioWare, PopCap and Social/Mobile studios. Our CODM regularly reviews the results of each of the operating labels. Due to their similar economic characteristics, products, and distribution methods, all six of the operating labels are aggregated into one Reportable Segment (the “EA Labels” segment) as shown below. In addition to assessing performance and allocating resources based on our operating segments, to a lesser degree, our CODM also reviews results based on geographic performance.
The following table summarizes the financial performance of the EA Labels segment and a reconciliation of the EA Labels segment's loss to our consolidated operating income for the three months ended June 30, 2012 and 2011. Prior periods reported below have been restated to reflect our current EA Labels reporting segment structure (in millions):
 
Three Months Ended
June 30,
 
2012
 
2011
EA Labels segment:
 
 
 
Net revenue before revenue deferral
$
467

 
$
516

Depreciation and amortization
(16
)
 
(15
)
Other expenses
(461
)
 
(534
)
EA Labels segment loss
(10
)
 
(33
)
Reconciliation to consolidated operating income:
 
 
 
Other:
 
 
 
Revenue deferral
(315
)
 
(250
)
Recognition of revenue deferral
779

 
725

Other net revenue
24

 
8

Depreciation and amortization
(34
)
 
(26
)
Acquisition-related contingent consideration
20

 
(2
)
Restructuring and other charges
(27
)
 
(18
)
Stock-based compensation
(39
)
 
(38
)
Other expenses
(183
)
 
(139
)
Consolidated operating income
$
215

 
$
227

EA Labels segment loss differs from consolidated operating income primarily due to the exclusion of (1) certain corporate and other functional costs that are not allocated to EA Labels, (2) the deferral of certain net revenue related to online-enabled packaged goods and digital content (see Note 8 for additional information regarding deferred net revenue (packaged goods and digital content)), and (3) our Switzerland distribution revenue and expenses that is not allocated to EA Labels. Our CODM reviews assets on a consolidated basis and not on a segment basis.
As we continue to evolve our business and more of our products are delivered to consumers digitally via the Internet, management places a greater emphasis and focus on assessing its performance through a review of net revenue by revenue composition rather than net revenue by platform. Information about our total net revenue by revenue composition for the three months ended June 30, 2012 and 2011 is presented below (in millions): 

24


 
Three Months Ended
June 30,
 
2012
 
2011
Publishing and other
$
592

 
$
647

Wireless, Internet-derived, advertising (digital)
342

 
232

Distribution
21

 
120

Net revenue
$
955

 
$
999

Information about our operations in North America, Europe and Asia as of and for the three months ended June 30, 2012 and 2011 is presented below (in millions): 
 
Three Months Ended
June 30,
 
2012
 
2011
Net revenue from unaffiliated customers
 
 
 
North America
$
450

 
$
501

Europe
435

 
438

Asia
70

 
60

Net revenue
$
955

 
$
999

 
 
As of June 30,
 
2012
 
2011
Long-lived assets
 
 
 
North America
$
2,123

 
$
1,289

Europe
452

 
440

Asia
46

 
53

Total
$
2,621

 
$
1,782

Our direct sales to GameStop Corp. represented approximately 11 percent and 18 percent of total net revenue for the three months ended June 30, 2012 and 2011, respectively.

(15) IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In December 2011, the FASB issued ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, which creates new disclosure requirements about the nature of an entity’s rights of offset and related arrangements associated with its financial instruments and derivative instruments. The disclosure requirements are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods therein, with retrospective application required. The new disclosures are designed to make financial statements that are prepared under U.S. Generally Accepted Accounting Principles more comparable to those prepared under International Financial Reporting Standards. We are currently evaluating the impact of ASU 2011-11 on our Condensed Consolidated Financial Statements.


25


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
Electronic Arts Inc.:
We have reviewed the condensed consolidated balance sheets of Electronic Arts Inc. and subsidiaries (the Company) as of June 30, 2012 and July 2, 2011, and the related condensed consolidated statements of operations, comprehensive income, and cash flows for the three-month periods ended June 30, 2012 and July 2, 2011. These condensed consolidated financial statements are the responsibility of the Company's management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Electronic Arts Inc. and subsidiaries as of March 31, 2012, and the related consolidated statements of operations, stockholders' equity and comprehensive income (loss), and cash flows for the year then ended (not presented herein); and in our report dated May 25, 2012, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of March 31, 2012 is fairly stated, in all material respects, in relation to the consolidated balance sheet for which it has been derived.

 
/s/   KPMG LLP
Santa Clara, California
August 3, 2012

26


Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY NOTE ABOUT FORWARD-LOOKING STATEMENTS
This Quarterly Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact, made in this Quarterly Report are forward looking. Examples of forward-looking statements include statements related to industry prospects, our future economic performance including anticipated revenues and expenditures, results of operations or financial position, and other financial items, our business plans and objectives, including our intended product releases, and may include certain assumptions that underlie the forward-looking statements. We use words such as “anticipate,” “believe,” “expect,” “intend,” “estimate” (and the negative of any of these terms), “future” and similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk and reflect management’s current expectations, and involve subjects that are inherently uncertain and difficult to predict. Our actual results could differ materially from those in the forward-looking statements. We will not necessarily update information if any forward-looking statement later turns out to be inaccurate. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed in this report under the heading “Risk Factors” in Part II, Item 1A, as well as in our Annual Report on Form 10-K for the fiscal year ended March 31, 2012 as filed with the Securities and Exchange Commission (“SEC”) on May 25, 2012 and in other documents we have filed with the SEC.

OVERVIEW
The following overview is a high-level discussion of our operating results, as well as some of the trends and drivers that affect our business. Management believes that an understanding of these trends and drivers is important in order to understand our results for the three months ended June 30, 2012, as well as our future prospects. This summary is not intended to be exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided elsewhere in this Form 10-Q, including in the remainder of “Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”),” “Risk Factors,” and the Condensed Consolidated Financial Statements and related Notes. Additional information can be found in the “Business” section of our Annual Report on Form 10-K for the fiscal year ended March 31, 2012 as filed with the SEC on May 25, 2012 and in other documents we have filed with the SEC.
About Electronic Arts
We develop, market, publish and distribute game software content and services that can be played by consumers on a variety of platforms, including video game consoles (such as the Sony PLAYSTATION 3, Microsoft Xbox 360, and Nintendo Wii), personal computers, mobile devices (such as the Apple iPhone and Google Android compatible phones), tablets and electronic readers (such as the Apple iPad and Amazon Kindle), and the Internet. Our ability to publish games across multiple platforms, through multiple distribution channels, and directly to consumers (online and wirelessly) has been, and will continue to be, a cornerstone of our product strategy. We have generated substantial growth in new business models and alternative revenue streams (such as subscription, micro-transactions, and advertising) based on the continued expansion of our online and wireless platform. Some of our games are based on our own wholly-owned intellectual property (e.g., Battlefield, Mass Effect, Need for Speed, The Sims, Bejeweled, and Plants v. Zombies), and some of our games are based on content that we license from others (e.g., FIFA, Madden NFL, and Star Wars: The Old Republic). Our goal is to turn our core intellectual properties into year-round businesses available on a range of platforms. Our products and services may be purchased through physical and online retailers, platform providers such as console manufacturers and mobile carriers via digital downloads, as well as directly through our own distribution platform, including online portals such as Origin and Play4Free.
Financial Results
Total net revenue for the three months ended June 30, 2012 was $955 million, a decrease of $44 million, or 4 percent, as compared to the three months ended June 30, 2011. At June 30, 2012, deferred net revenue associated with sales of online-enabled packaged goods and digital content decreased by $464 million as compared to March 31, 2012, directly increasing the amount of reported net revenue during the three months ended June 30, 2012. At June 30, 2011, deferred net revenue associated with sales of online-enabled packaged goods and digital content decreased by $475 million as compared to March 31, 2011, directly increasing the amount of reported net revenue during the three months ended June 30, 2011. Without this $11 million change in deferred net revenue, reported net revenue would have decreased by approximately $33 million, or 6 percent, during the three months ended June 30, 2012. This decrease was primarily the result of lower revenue from distribution products during the three months ended June 30, 2012 as compared to the three months ended June 30, 2011. Net revenue for the three months ended June 30, 2012 was driven by Battlefield 3, FIFA 2012, and Mass Effect 3.


27


Net income for the three months ended June 30, 2012 was $201 million as compared to $221 million for the three months ended June 30, 2011. Diluted earnings per share for the three months ended June 30, 2012 was $0.63 as compared to a diluted earnings per share of $0.66 for the three months ended June 30, 2011. Net income decreased for the three months ended June 30, 2012 as compared to the three months ended June 30, 2011 primarily as a result of (1) a $25 million increase in personnel-related expenses due primarily to an 11 percent increase in headcount, (2) a $9 million decrease in gross profit due to a 4 percent decrease in net revenue, and (3) a $9 million increase in restructuring and other costs. These decreases in net income were partially offset by a $22 million decrease in acquisition-related contingent consideration charges.
Trends in Our Business
Digital Content Distribution and Services. Consumers are spending an ever-increasing portion of their money and time on interactive entertainment that is accessible online, or through mobile digital devices such as smart phones, or through social networks such as Facebook. We provide a variety of online-delivered products and services including through our Origin platform. Many of our games that are available as packaged goods products are also available through direct online download through the Internet. We also offer online-delivered content and services that are add-ons or related to our packaged goods products such as additional game content or enhancements of multiplayer services. Further, we provide other games, content and services that are available only via electronic delivery, such as Internet-only games and game services, and games for mobile devices. 

Advances in mobile technology have resulted in a variety of new and evolving devices that are being used to play games by an ever-broadening base of consumers. We have responded to these advances in technology and consumer acceptance of digital distribution by offering different sales models, such as subscription services, online downloads for a one-time fee, micro-transactions and advertising-supported free-to-play games and game sites. In addition, we offer our consumers the ability to play a game across platforms on multiple devices. We significantly increased the revenues that we derive from wireless, Internet-derived and advertising (digital) products and services from $743 million in fiscal year 2011 to $1,159 million in fiscal year 2012 and we expect this portion of our business to continue to grow in fiscal 2013 and beyond.
Wireless and Other Emerging Platforms. Advances in technology have resulted in a variety of platforms for interactive entertainment. Examples include wireless technologies, streaming gaming services, and Internet platforms. Our efforts in wireless interactive entertainment are focused in downloadable games for mobile devices. These platforms grow the consumer base for our business while also providing competition to existing established video game platforms. We expect sales of games for wireless and other emerging platforms to continue to be an important part of our business.

Growth of Casual and Social Games. The popularity of wireless and other emerging gaming platforms such as smart phones, tablets and social networking sites, such as Facebook, has led to the growth of casual and social gaming. Casual and social games are characterized by their mass appeal, simple controls, flexible monetization including free-to-play and micro-transaction business models, and fun and approachable gameplay. These games appeal to a larger consumer demographic of younger and older players and more female players than video games played on console devices. These areas are among the fastest growing segments of our sector and we have responded to this opportunity by developing casual and social games based on our established intellectual properties such as The Sims, FIFA and Battlefield, and with our acquisition of PopCap Games. We expect sales of casual and social games for wireless and other emerging platforms to continue to be an important part of our business.
Concentration of Sales Among the Most Popular Games. We see a larger portion of packaged goods games sales concentrated on the most popular titles, and those titles are typically sequels of prior games. We have responded to this trend by significantly reducing the number of games that we produce to provide greater focus on our most promising intellectual properties. We published 36 primary packaged goods titles in fiscal year 2011, 22 in fiscal year 2012 and in fiscal year 2013, we expect to release 14 primary packaged goods titles.

Evolving Sales Patterns. Our business has evolved from a traditional packaged goods business model to one where our games are played on a variety of platforms including mobile devices and social networking sites. Our strategy is to transform our core intellectual properties into year-round businesses, with a steady flow of downloadable content and extensions on new platforms. Our increasingly digital, multi-platform business no longer reflects the retail sales patterns associated with traditional packaged goods launches. For example, we offer our consumers additional services and/or additional content available through online services to further enhance the gaming experience and extend the time that consumers play our games after their initial purchase. Our social and casual games offer free-to-play and micro-transaction models. We also offer subscription-based products, such as our massively multi-player online (“MMO”) role-playing game Star Wars: The Old Republic. The revenues we derive from these services have become increasingly more significant year-over-year. Our service revenue represented 26 percent and 11 percent of total revenues in the three months ended June 30, 2012 and 2011, respectively.

28


    
Recent Developments

Stock Repurchase Program. In February 2011, we announced that our Board of Directors authorized a program to repurchase up to $600 million of our common stock over the next 18 months. We completed our program in April 2012. We repurchased approximately 32 million shares in the open market since the commencement of the program, including pursuant to pre-arranged stock trading plans. During the three months ended June 30, 2012, we repurchased and retired approximately 4 million shares of our common stock for approximately $71 million, net of commissions.

In July 2012, our Board of Directors authorized a new program to repurchase up to $500 million of our common stock. Under the program, we may purchase stock in the open market or through privately-negotiated transactions in accordance with applicable securities laws, including pursuant to pre-arranged stock trading plans.  The timing and actual amount of the stock repurchases will depend on several factors including price, capital availability, regulatory requirements, alternative investment opportunities and other market conditions. We are not obligated to repurchase any specific number of shares under the program and the repurchase program may be modified, suspended or discontinued at any time.

International Operations and Foreign Currency Exchange Impact. International sales (revenue derived from countries other than Canada and the United States), are a fundamental part of our business. Net revenue from international sales accounted for approximately 53 percent of our total net revenue during the three months ended June 30, 2012 and approximately 50 percent of our total net revenue during the three months ended June 30, 2011. Our net revenue is impacted by foreign exchange rates during the reporting period associated with net revenue before revenue deferral, as well as the foreign exchange rates associated with the recognition of deferred net revenue of online-enabled packaged goods and digital content that were established at the time we recorded this deferred net revenue on our Consolidated Balance Sheets. The foreign exchange rates during the reporting period may not always move in the same direction as the foreign exchange rate impact associated with the recognition of deferred net revenue of online-enabled packaged goods and digital content. During the three months ended June 30, 2012, foreign exchange rates had an overall unfavorable impact on our net revenue of approximately $5 million, or 1 percent. In addition, our international investments and our cash and cash equivalents denominated in foreign currencies are subject to fluctuations in foreign currency exchange rates. If the U.S. dollar strengthens against these currencies, then foreign exchange rates may have an unfavorable impact on our results of operations and our financial condition.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Condensed Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, contingent assets and liabilities, and revenue and expenses during the reporting periods. The policies discussed below are considered by management to be critical because they are not only important to the portrayal of our financial condition and results of operations, but also because application and interpretation of these policies requires both management judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.

Revenue Recognition, Sales Returns, Allowances and Bad Debt Reserves
We derive revenue principally from sales of interactive software games (1) on video game consoles (such as the PLAYSTATION 3, Xbox 360 and Wii) and PCs, (2) on mobile devices (such the Apple iPhone and Google compatible Android phones), (3) on tablets and electronic readers such as the Apple iPad and Amazon Kindle, and (4) from software and content and online game services associated with these products. We evaluate revenue recognition based on the criteria set forth in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 985-605, Software: Revenue Recognition, and Staff Accounting Bulletin (“SAB”) No. 101, Revenue Recognition, as revised by SAB No. 104, Revenue Recognition. We classify our revenue as either Product revenue or Service and other revenue.

We evaluate and recognize revenue when all four of the following criteria are met:

Evidence of an arrangement. Evidence of an agreement with the customer that reflects the terms and conditions to deliver products must be present.

Delivery. Delivery is considered to occur when a product is shipped and the risk of loss and rewards of ownership have been transferred to the customer. For services, delivery is considered to occur as the service is provided.

Fixed or determinable fee. If a portion of the arrangement fee is not fixed or determinable, we recognize revenue as

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the amount becomes fixed or determinable.

Collection is deemed probable. We conduct a credit review of each customer involved in a significant transaction to determine the creditworthiness of the customer. Collection is deemed probable if we expect the customer to be able to pay amounts under the arrangement as those amounts become due. If we determine that collection is not probable, we recognize revenue when collection becomes probable (generally upon cash collection).

Determining whether and when some of these criteria have been satisfied often involves assumptions and management judgments that can have a significant impact on the timing and amount of revenue we report in each period. Changes to any of these assumptions and judgments, could cause a material increase or decrease in the amount of revenue that we report in a particular period.

Multiple-element arrangements

We enter into multiple-element revenue arrangements in which we may provide a combination of game software, updates or additional content and online game services. For some software products we may provide updates or additional content (“digital content”) to be delivered via the Internet that can be used with the original software product. In many cases we separately sell this digital content for an additional fee. In other transactions, we may have an obligation to provide incremental unspecified digital content in the future without an additional fee (i.e., updates on a when-and-if-available basis) or we may offer an online “matchmaking” service that permits consumers to play against each other via the Internet. Collectively, we refer to these as software-related offerings. In those situations where we do not require an additional fee for the software-related offerings, we account for the sale of the software product and software-related offerings as a “bundled” sale, or multiple element arrangement, in which we sell both the software product and relating offerings for one combined price. Generally, we do not have vendor specific objective evidence (“VSOE”) for the software-related offerings and thus, we defer net revenue from sales of these games and recognize the revenue from the bundled sales games over the period the offering will be provided (the “offering period”). If the period is not defined, we recognize revenue over the estimated offering period, which is generally estimated to be six months, beginning in the month after delivery. In addition, determining whether we have an implicit obligation to provide incremental unspecified future digital content without an additional fee can be difficult. Determining the estimated offering period is inherently subjective and is subject to regular revision based on historical online usage.

Determining whether an element of a transaction constitutes an online game service or a digital content download of a product requires judgment and can be difficult. The accounting for these transactions is significantly different. Revenue from product downloads is generally recognized when the download is made available (assuming all other recognition criteria are met). Revenue from an online game service is recognized as the service is rendered. If the period is not defined, we recognize the revenue over the estimated service period. For example, our MMO games have an estimated service period of eighteen months, beginning in the month after delivery.

For our software and software-related multiple element arrangements (i.e., software game bundled with software-related offerings), we must make assumptions and judgments in order to (1) determine whether and when each element is delivered, (2) determine whether the undelivered elements are essential to the functionality of the delivered elements, (3) determine whether VSOE exists for each undelivered element, and (4) allocate the total price among the various elements. Changes to any of these assumptions and judgments, or changes to the elements in the arrangement, could cause a material increase or decrease in the amount of revenue that we report in a particular period.

In some of our multiple element arrangements, we sell tangible products with software and/or software-related offerings. These tangible products are generally either peripherals or ancillary collectors' items. Revenue for these arrangements is allocated to each separate unit of accounting for each deliverable using the relative selling prices of each deliverable in the arrangement based on the selling price hierarchy described below. If the arrangement contains more than one software deliverable, the arrangement consideration is allocated to the software deliverables as a group and then allocated to each software deliverable in accordance with ASC 985-605.
We determine the selling price for a tangible product deliverable based on the following selling price hierarchy: VSOE (i.e., the price we charge when the tangible product is sold separately) if available, third-party evidence (“TPE”) of fair value (i.e., the price charged by others for similar tangible products) if VSOE is not available, or our best estimate of selling price (“BESP”) if neither VSOE nor TPE is available. Determining the BESP is a subjective process that is based on multiple factors including, but not limited to, recent selling prices and related discounts, market conditions, customer classes, sales channels and other factors.


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We reduce revenue for estimated future returns, price protection, and other offerings, which may occur with our customers and channel partners. Price protection represents the right to receive a credit allowance in the event we lower our wholesale price on a particular product. The amount of the price protection is generally the difference between the old price and the new price. In certain countries, we have stock-balancing programs for our PC and video game system software products, which allow for the exchange of these software products by resellers under certain circumstances. It is our general practice to exchange software products or give credits rather than to give cash refunds.

In certain countries, from time to time, we decide to provide price protection for our software products. When evaluating the adequacy of sales returns and price protection allowances, we analyze historical returns, current sell-through of distributor and retailer inventory of our software products, current trends in retail and the video game industry, changes in customer demand and acceptance of our software products, and other related factors. In addition, we monitor the volume of sales to our channel partners and their inventories, as substantial overstocking in the distribution channel could result in high returns or higher price protection costs in subsequent periods.

In the future, actual returns and price protections may materially exceed our estimates as unsold software products in the distribution channels are exposed to rapid changes in consumer preferences, market conditions or technological obsolescence due to new platforms, product updates or competing software products. While we believe we can make reliable estimates regarding these matters, these estimates are inherently subjective. Accordingly, if our estimates change, our returns and price protection reserves would change, which would impact the total net revenue we report. For example, if actual returns and/or price protection were significantly greater than the reserves we have established, our actual results would decrease our reported total net revenue. Conversely, if actual returns and/or price protection were significantly less than our reserves, this would increase our reported total net revenue. In addition, if our estimates of returns and price protection related to online-enabled packaged goods software products change, the amount of deferred net revenue we recognize in the future would change.

Significant management judgment is required to estimate our allowance for doubtful accounts in any accounting period. We determine our allowance for doubtful accounts by evaluating customer creditworthiness in the context of current economic trends and historical experience. Depending upon the overall economic climate and the financial condition of our customers, the amount and timing of our bad debt expense and cash collection could change significantly.

Fair Value Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) often requires us to determine the fair value of a particular item in order to fairly present our financial statements. Without an independent market or another representative transaction, determining the fair value of a particular item requires us to make several assumptions that are inherently difficult to predict and can have a material impact on the accounting.

There are various valuation techniques used to estimate fair value. These include (1) the market approach where market transactions for identical or comparable assets or liabilities are used to determine the fair value, (2) the income approach, which uses valuation techniques to convert future amounts (for example, future cash flows or future earnings) to a single present value amount, and (3) the cost approach, which is based on the amount that would be required to replace an asset. For many of our fair value estimates, including our estimates of the fair value of acquired intangible assets, we use the income approach. Using the income approach requires the use of financial models, which require us to make various estimates including, but not limited to (1) the potential future cash flows for the asset or liability being measured, (2) the timing of receipt or payment of those future cash flows, (3) the time value of money associated with the expected receipt or payment of such cash flows, and (4) the inherent risk associated with the cash flows (risk premium). Making these cash flow estimates are inherently difficult and subjective, and if any of the estimates used to determine the fair value using the income approach turns out to be inaccurate, our financial results may be negatively impacted. Furthermore, relatively small changes in many of these estimates can have a significant impact to the estimated fair value resulting from the financial models or the related accounting conclusion reached. For example, a relatively small change in the estimated fair value of an asset may change a conclusion as to whether an asset is impaired.

While we are required to make certain fair value assessments associated with the accounting for several types of transactions, the following areas are the most sensitive to these assessments:

Business Combinations. We must estimate the fair value of assets acquired, liabilities and contingencies assumed, acquired in-process technology, and contingent consideration issued in a business combination. Our assessment of the estimated fair value of each of these can have a material effect on our reported results as intangible assets are amortized over various estimated useful lives. Furthermore, a change in the estimated fair value of an asset or liability often has a direct impact on the amount we recognize as goodwill, an asset that is not amortized. Determining the fair value of assets acquired requires an assessment of

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the highest and best use or the expected price to sell the asset and the related expected future cash flows. Determining the fair value of acquired in-process technology also requires an assessment of our expectations related to the use of that asset. Determining the fair value of an assumed liability requires an assessment of the expected cost to transfer the liability. Determining the fair value of contingent consideration issued requires an assessment of the expected future cash flows over the period in which the obligation is expected to be settled, and applying a discount rate that appropriately captures a market participant's view of the risk associated with the obligation. This fair value assessment is also required in periods subsequent to a business combination. Such estimates are inherently difficult and subjective and can have a material impact on our Condensed Consolidated Financial Statements.

Assessment of Impairment of Goodwill, Intangibles, and Other Long-Lived Assets. Current accounting standards require that we assess the recoverability of our finite lived acquisition-related intangible assets and other long-lived assets whenever events or changes in circumstances indicate the remaining value of the assets recorded on our Condensed Consolidated Balance Sheets is potentially impaired. In order to determine if a potential impairment has occurred, management must make various assumptions about the estimated fair value of the asset by evaluating future business prospects and estimated future cash flows. For some assets, our estimated fair value is dependent upon predicting which of our products will be successful. This success is dependent upon several factors, which are beyond our control, such as which operating platforms will be successful in the marketplace. Also, our revenue and earnings are dependent on our ability to meet our product release schedules.

In assessing impairment on our goodwill, we first analyze qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If we conclude it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, we do not need to perform the two-step impairment test. If based on that assessment, we believe it is more likely than not that the fair value of its reporting units is less than its carrying value, a two-step goodwill impairment test will be performed. The first step measures for impairment by applying fair value-based tests at the reporting unit level. The second step (if necessary) measures the amount of impairment by applying fair value-based tests to the individual assets and liabilities within each reporting unit. Our reporting units are determined by the components of our operating segments that constitute a business for which (1) discrete financial information is available and (2) segment management regularly reviews the operating results of that component.

To determine the fair value of each reporting unit used in the first step, we use the market approach, which utilizes comparable companies' data, the income approach, which utilizes discounted cash flows, or a combination thereof. Determining whether an event or change in circumstances does or does not indicate that the fair value of a reporting unit is below its carrying amount is inherently subjective. Each step requires us to make judgments and involves the use of significant estimates and assumptions. These estimates and assumptions include long-term growth rates, tax rates, and operating margins used to calculate projected future cash flows, risk-adjusted discount rates based on a weighted average cost of capital, future economic and market conditions and determination of appropriate market comparables. These estimates and assumptions have to be made for each reporting unit evaluated for impairment. As of our last annual assessment of goodwill in the fourth quarter of fiscal year 2012, we concluded that the estimated fair values of each of our reporting units significantly exceeded their carrying amounts and we have not identified any indicators of impairment since that assessment. Our estimates for market growth, our market share and costs are based on historical data, various internal estimates and certain external sources, and are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying business. Our business consists of developing, marketing and distributing video game software using both established and emerging intellectual properties and our forecasts for emerging intellectual properties are based upon internal estimates and external sources rather than historical information and have an inherently higher risk of inaccuracy. If future forecasts are revised, they may indicate or require future impairment charges. We base our fair value estimates on assumptions we believe to be reasonable, but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates.

Assessment of Impairment of Short-Term Investments and Marketable Equity Securities. We periodically review our short-term investments and marketable equity securities for impairment. Our short-term investments consist of securities with remaining maturities greater than three months at the time of purchase and our marketable equity securities consist of investments in common stock of publicly traded companies, both are accounted for as available-for-sale securities. Unrealized gains and losses on our short-term investments and marketable equity securities are recorded as a component of accumulated other comprehensive income in stockholders' equity, net of tax, until either (1) the security is sold, (2) the security has matured, or (3) we determine that the fair value of the security has declined below its adjusted cost basis and the decline is other-than-temporary. Realized gains and losses on our short-term investments and marketable equity securities are calculated based on the specific identification method and are reclassified from accumulated other comprehensive income to interest and other income (expense), net, and gains (losses) on strategic investments, net, respectively. Determining whether the decline in fair value is other-than-temporary requires management judgment based on the specific facts and circumstances of each security. The

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ultimate value realized on these securities is subject to market price volatility until they are sold. We consider various factors in determining whether we should recognize an impairment charge, including the credit quality of the issuer, the duration that the fair value has been less than the adjusted cost basis, severity of the impairment, reason for the decline in value and potential recovery period, the financial condition and near-term prospects of the investees, and our intent to sell and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value, any contractual terms impacting the prepayment or settlement process, as well as, if we would be required to sell an investment due to liquidity or contractual reasons before its anticipated recovery. Our ongoing consideration of these factors could result in impairment charges in the future, which could have a material impact on our financial results.

Assessment of Inventory Obsolescence. We regularly review inventory quantities on-hand. We write down inventory based on excess or obsolete inventories determined primarily by future anticipated demand for our products. Inventory write-downs are measured as the difference between the cost of the inventory and market value, based upon assumptions about future demand that are inherently difficult to assess. At the point of a loss recognition, a new, lower cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis.

Royalties and Licenses

Our royalty expenses consist of payments to (1) content licensors, (2) independent software developers, and (3) co-publishing and distribution affiliates. License royalties consist of payments made to celebrities, professional sports organizations, movie studios and other organizations for our use of their trademarks, copyrights, personal publicity rights, content and/or other intellectual property. Royalty payments to independent software developers are payments for the development of intellectual property related to our games. Co-publishing and distribution royalties are payments made to third parties for the delivery of products.

Royalty-based obligations with content licensors and distribution affiliates are either paid in advance and capitalized as prepaid royalties or are accrued as incurred and subsequently paid. These royalty-based obligations are generally expensed to cost of revenue generally at the greater of the contractual rate or an effective royalty rate based on the total projected net revenue for contracts with guaranteed minimums. Significant judgment is required to estimate the effective royalty rate for a particular contract. Because the computation of effective royalty rates requires us to project future revenue, it is inherently subjective as our future revenue projections must anticipate a number of factors, including (1) the total number of titles subject to the contract, (2) the timing of the release of these titles, (3) the number of software units we expect to sell, which can be impacted by a number of variables, including product quality, the timing of the title's release and competition, and (4) future pricing. Determining the effective royalty rate for our titles is particularly challenging due to the inherent difficulty in predicting the popularity of entertainment products. Accordingly, if our future revenue projections change, our effective royalty rates would change, which could impact the amount and timing of royalty expense we recognize.

Prepayments made to thinly capitalized independent software developers and co-publishing affiliates are generally made in connection with the development of a particular product, and therefore, we are generally subject to development risk prior to the release of the product. Accordingly, payments that are due prior to completion of a product are generally expensed to research and development over the development period as the services are incurred. Payments due after completion of the product (primarily royalty-based in nature) are generally expensed as cost of revenue.

Our contracts with some licensors include minimum guaranteed royalty payments, which are initially recorded as an asset and as a liability at the contractual amount when no performance remains with the licensor. When performance remains with the licensor, we record guarantee payments as an asset when actually paid and as a liability when incurred, rather than recording the asset and liability upon execution of the contract. Royalty liabilities are classified as current liabilities to the extent such royalty payments are contractually due within the next 12 months.
 
Each quarter, we also evaluate the expected future realization of our royalty-based assets, as well as any unrecognized minimum commitments not yet paid to determine amounts we deem unlikely to be realized through product sales. Any impairments or losses determined before the launch of a product are charged to research and development expense. Impairments or losses determined post-launch are charged to cost of revenue. We evaluate long-lived royalty-based assets for impairment generally using undiscounted cash flows when impairment indicators exist. Unrecognized minimum royalty-based commitments are accounted for as executory contracts, and therefore, any losses on these commitments are recognized when the underlying intellectual property is abandoned (i.e., cease use) or the contractual rights to use the intellectual property are terminated.


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Income Taxes

We recognize deferred tax assets and liabilities for both the expected impact of differences between the financial statement amount and the tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax losses and tax credit carry forwards. We record a valuation allowance against deferred tax assets when it is considered more likely than not that all or a portion of our deferred tax assets will not be realized. In making this determination, we are required to give significant weight to evidence that can be objectively verified. It is generally difficult to conclude that a valuation allowance is not needed when there is significant negative evidence, such as cumulative losses in recent years. Forecasts of future taxable income are considered to be less objective than past results, particularly in light of the economic environment. Therefore, cumulative losses weigh heavily in the overall assessment.
In addition to considering forecasts of future taxable income, we are also required to evaluate and quantify other possible sources of taxable income in order to assess the realization of our deferred tax assets, namely the reversal of existing deferred tax liabilities, the carry back of losses and credits as allowed under current tax law, and the implementation of tax planning strategies. Evaluating and quantifying these amounts involves significant judgments. Each source of income must be evaluated based on all positive and negative evidence; this evaluation involves assumptions about future activity. Certain taxable temporary differences that are not expected to reverse during the carry forward periods permitted by tax law cannot be considered as a source of future taxable income that may be available to realize the benefit of deferred tax assets.
Based on the assumptions and requirements noted above, we have recorded a valuation allowance against most of our U.S. deferred tax assets. In addition, we expect to provide a valuation allowance on future U.S. tax benefits until we can sustain a level of profitability or until other significant positive evidence arises that suggest that these benefits are more likely than not to be realized.
In the ordinary course of our business, there are many transactions and calculations where the tax law and ultimate tax determination is uncertain. As part of the process of preparing our Condensed Consolidated Financial Statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate prior to the completion and filing of tax returns for such periods. This process requires estimating both our geographic mix of income and our uncertain tax positions in each jurisdiction where we operate. These estimates involve complex issues and require us to make judgments about the likely application of the tax law to our situation, as well as with respect to other matters, such as anticipating the positions that we will take on tax returns prior to our actually preparing the returns and the outcomes of disputes with tax authorities. The ultimate resolution of these issues may take extended periods of time due to examinations by tax authorities and statutes of limitations. In addition, changes in our business, including acquisitions, changes in our international corporate structure, changes in the geographic location of business functions or assets, changes in the geographic mix and amount of income, as well as changes in our agreements with tax authorities, valuation allowances, applicable accounting rules, applicable tax laws and regulations, rulings and interpretations thereof, developments in tax audit and other matters, and variations in the estimated and actual level of annual pre-tax income can affect the overall effective income tax rate.
We historically have considered undistributed earnings of our foreign subsidiaries to be indefinitely reinvested outside of the United States, and accordingly, no U.S. taxes have been provided thereon. We currently intend to continue to indefinitely reinvest the undistributed earnings of our foreign subsidiaries outside of the United States.

RESULTS OF OPERATIONS
Our fiscal year is reported on a 52- or 53-week period that ends on the Saturday nearest March 31. Our results of operations for the fiscal years ending or ended, as the case may be, March 31, 2013 and 2012 contain 52 weeks each and ends or ended, as the case may be, on March 30, 2013 and March 31, 2012, respectively. Our results of operations for the three months ended June 30, 2012 and 2011 contained 13 weeks each, and ended on June 30, 2012 and July 2, 2011, respectively. For simplicity of disclosure, all fiscal periods are referred to as ending on a calendar month end.
Net Revenue
Net revenue consists of sales generated from (1) video games sold as packaged goods or as digital downloads and designed for play on video game consoles (such as the PLAYSTATION 3, Xbox 360 and Wii), and PCs, (2) video games for mobile devices (such as the Apple iPhone and Google Android compatible phones), (3) video games for tablets and electronic readers such as the Apple iPad and Amazon Kindle, (4) software products and content and online game services associated with these products, (5) programming third-party websites with our game content, (6) allowing other companies to manufacture and sell our products in conjunction with other products, and (7) advertisements on our online web pages and in our games.

We provide three different measures of our Net Revenue. Two of these measures are presented in accordance with U.S. GAAP -

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(1) Net Revenue by Product revenue and Service and other revenue and (2) Net Revenue by Geography. The third measure is a non-GAAP financial measure - Net Revenue before Revenue Deferral by Revenue Composition, which is primarily based on method of distribution. We use this third non-GAAP financial measure internally to evaluate our operating performance, when planning, forecasting and analyzing future periods, and when assessing the performance of our management team.

Management places a greater emphasis and focus on assessing our business through a review of the Net Revenue before Revenue Deferral by Revenue Composition than by Net Revenue by Product revenue and Service and other revenue. These two measures differ as (1) Net Revenue by Product revenue and Service and other revenue reflects the deferral and recognition of revenue in periods subsequent to the date of sale due to U.S. GAAP while Net Revenue before Revenue Deferral by Revenue Composition does not, and (2) both measures contain a different aggregation of sales from one another. For instance, Service and other revenue does not include the majority of our full-game digital download and mobile sales that are fully included in our Digital revenue. Further, Service and other revenue includes all of our revenue associated with MMO games while software sales associated with our MMOs are included in either Digital revenue or Publishing and other revenue depending on whether the sale was a full-game digital download or a packaged goods sale.

Net Revenue by Product Revenue and Service and Other Revenue

Our total net revenue by product revenue and service and other revenue for the three months ended June 30, 2012 and 2011 was as follows (in millions):
 
Three Months Ended June 30,
 
2012
 
2011
 
$ Change
 
% Change
Net revenue:
 
 
 
 
 
 
 
Product
$
702

 
$
894

 
$
(192
)
 
(21
)%
Service and other
253

 
105

 
148

 
141
 %
Total net revenue
$
955

 
$
999

 
$
(44
)
 
(4
)%

Product Revenue

Our product revenue includes revenue associated with the sale of game software, whether delivered via a disc (i.e., packaged goods) or via the Internet (i.e., full-game download), that do not require our continuous hosting support, and licensing of game software to third-parties. This excludes game software from our MMO games (both game and subscription sales), which is included in service and other revenue as such game software requires continuous hosting support. Product revenue also includes mobile games that do not have an online service component and sales of tangible products such as hardware, peripherals, or collectors' items.

For the three months ended June 30, 2012, product revenue was $702 million, primarily driven by Battlefield 3, Mass Effect 3, and FIFA 2012. Product revenue for the three months ended June 30, 2012 decreased $192 million, or 21 percent, as compared to the three months ended June 30, 2011. This decrease was driven by a $517 million decrease primarily from the Portal, Crysis, Need for Speed, and Dragon Age franchises. This decrease was offset by a $325 million increase primarily from the Battlefield, Mass Effect, and FIFA Street franchises.

Service and Other Revenue

Our service revenue includes revenue recognized from games or related content that requires our hosting support to provide substantial gaming experience, and time-based subscriptions. This includes (1) subscriptions for our Pogo-branded online game services, (2) MMO games (both game and subscription sales), (3) entitlements to content that are delivered through hosting services (e.g., micro-transactions for Internet-based, social network and mobile games which includes “freemium” games), and (4) allocated service revenue from sales of online-enable packaged goods with an online service component (i.e., “matchmaking” services). Our other revenue includes non-software licensing and advertising revenue.

For the three months ended